Widespread preoccupation with implementation issues around the January 2005 switch to international financial reporting standards (IFRS) is tending to obscure the need for business to focus on strategic value in the new environment.
A recent in-depth PwC survey of 197 listed Australian companies, ranging in capitalisation from $61 million to $57 billion, has highlighted key strategic value issues around the new standards.
IFRS, which comes into force on 1 January 2005, in many cases will replace an historic cost approach with rules that govern the recording of intangible assets and contractual positions at “fair value”. At the same time, they are likely to bring more volatility in earnings than under current generally accepted accounting principles (GAAP).
Compliance with accounting standards and evolving corporate governance principles will remain critical. However as the PwC Corporate Value Report accompanying the survey indicates, focusing only on compliance will almost certainly mean significant missed strategic opportunities for the management of value.
PwC partner Richard Stewart says that in the new environment, traditional rule-of-thumb methods of valuation such as price-earnings ratios (PEs) will often give a false impression of a company’s performance. “A much more holistic approach will be required to accurately gauge a company’s capacity to create sustained value,” he says.
Stewart says that a valuation methodology appropriate to the new environment should be built around a range of value indicators that is comprehensive. More importantly, it should integrate the multiple dimensions of value in a way that enables a single overall assessment to be made, while also quickly highlighting relative strengths and weaknesses in a company’s performance.
A recently developed PwC methodology of this kind, called the PwC ValueWeb, covers a comprehensive range of indicators, while also at a glance highlighting opportunities to pull particular levers to effect improvements and identifying other possible actions to build and sustain value overall.
The ValueWeb has been used to rank each of the 197 listed companies included in the Corporate Value Report. By standardising the indicators across all survey participants, a quartile ranking for each company has been plotted along each axis of the ValueWeb, and final rankings established according to the best overall value delivered for shareholders in 2003.
Using this methodology, the company that has emerged as the top performer in the PwC Corporate Value Report is Queensland wagering and gaming group UNiTAB.
A discussion with UNiTAB CEO Dick McIlwain
To further explore the real-world implications of the strategic approach to value, briefings discussed some of the issues with Dick McIlwain, CEO of UNiTAB, and with Greg Ward, CFO of Macquarie Bank Ltd, another top ValueWeb performer.
UNiTAB grew out of TAB Queensland, which was established in 1962 as a government authority to conduct legalised off-course totalisator betting in the State. In 1999 the Queensland Government sold its entire interest in TAB Queensland by a public float and in December 2002 the company became UNiTAB Limited.
UNiTAB and its subsidiaries now hold licences in Queensland, the Northern Territory and South Australia to conduct totalisator sports and race wagering and fixed odds sports and race betting by the Internet and telephone and through a retail network. The company has offered wagering over the Internet since 1998 and operates a race broadcasting network through 72 transmission sites in Queensland, South Australia and the Northern Territory.
The company provides hotels and clubs with gaming machine services in Queensland and the Northern Territory. This includes machine monitoring, venue management information and jackpot systems.
When briefings asked UNiTAB CEO Dick McIlwain whether his company looked at value in a holistic way similar to ValueWeb, he said that given UNiTAB’s particular investor profile, the company “must have in place a suite of business strategies which supports solid and continuous growth in earnings per share and dividends.”
According to McIlwain, this was reflected in a “planned and phased approach to acquisitions designed to produce reliable and predictable outcomes.”
McIlwain noted that TABs are generally seen as yield plays - and that UNiTAB’s total shareholder return (TSR) would normally reflect this type of investment profile. But “the exception to this rule is the growth we have been able to achieve from properly priced acquisitions which have exploited our strengths.”
He added: “We don’t need to focus too much on the various performance multiples so long as investors are confident that our approach to growth isn’t jeopardising our stock’s investment profile, and we respond with reliable earnings and solid, fully franked dividends. Any growth by acquisition must add to earnings per share within a relatively immediate timeframe.”
While the high returns on capital and low financial risk emerging from the PwC analysis of UNiTAB suggest a strong focus on disciplined capital management, McIlwain’s comment on this highlights the need for rigour across all areas: “We can’t rely on capital management alone,” he said. “There needs to be a disciplined approach to the business as a whole, which comes from the need to manage within the low gross margins which are a function of the regulatory framework surrounding our wagering licences.
“This discipline stretches beyond capital management to operating expenditures, product development and our human resources, as well as acquisitions.”
So how does UNiTAB approach capital spend, acquisitions and financing? “Our operating strategies produce guideposts for all our managers,” said McIlwain. “They produce a particular culture that just does not permit the kind of ego-driven expenditures that undergird ‘growth at any cost’ strategies, or corporate excess.”
Share price volatility
Many smaller listed companies with lower than average trading activity pose volatility risks for shareholders who want to trade the company’s stock, reducing potential value. In the case of UNiTAB, performance quality and consistency has underpinned relative stability in the company’s share register, though this may change somewhat following the end of a 10 per cent legislated cap on shareholdings in the company in August.
“The end of the shareholding cap might expose us to speculative stakebuilding and lead to some short-term share price volatility,” McIlwain said. “But leaving that aside, the underlying value of our stock will be there for long term shareholders for as long as the business produces consistent and reliable earnings. And the long term is the continuing priority for our managers.”
Asked whether UNiTAB consciously managed value creation, or whether it was a by-product of other factors such as operational efficiency, stakeholder management, costs and marketing savvy, McIlwain’s answer was emphatic: “Absolutely we manage for value creation,” he said. “The suggestion that cost cutting is an end in itself is a nonsense, even in this business. Our spending decisions turn on the net benefits they produce. We spend to get a return, and we will spend if the return is evident.”
The company’s commitment to in-store electronic information delivery systems is one example of this approach. McIlwain commented that these systems “represent a long-term investment in recasting the cost of producing our betting service that is already producing results. They improve the availability and timeliness of betting information for customers, while also reducing their reliance on expensive paper form and race lists.”
So, given that many studies have found that most mergers destroy value, at least in the short term, what does McIlwain see as the key to creating value during the current period of gaming industry consolidation?
“This is an easy question to answer,” he laughs. “Don’t pay too much, and leave the testosterone in the bedroom. Size doesn’t always matter. It’s performance that counts.”
PwC Top 10
The top 10 companies identified by the PwC ValueWeb methodology are as follows:
1
UNiTAB Ltd
2
Australian Stock Exchange Ltd
3
West Australian Newspaper Holdings Ltd
4
Macquarie Bank Ltd
5
Toll Holdings Ltd
6
Insurance Australia Group Ltd
7
Perpetual Trustees Australia Ltd
8
St. George Bank Ltd
9
Woolworths Ltd
10
Sigma Co Ltd
Seven keys to value
Emerging from the PwC Corporate Value Report are seven key insights:
1. Balancing risk and value
Performance can be achieved at the expense of unacceptable risk-taking. But a look at the list on the facing page of top 10 ValueWeb performers for the year shows that many companies perform very well while taking only moderate financial risks.
2. Benchmarking
Analysis of historical financial statistics, together with the market’s prospective view on uncertainty, highlights that one in 10 companies run high-risk profiles.
Awareness of risk is becoming a core management competency, yet many executives find benchmarking risk types particularly difficult. PwC partner Richard Stewart points out that the market itself can provide quantitative insights into these exposures for directors and managers: “Larger companies often rely on credit ratings to provide information about their exposure,” he says. “However, smaller listed companies (and unrated companies) have several sources of information at their disposal.
“Using these measures of financial risk enables boards and management to consider multiple ways of moving out of a danger zone, or at least to have awareness of the risks and the need to manage stakeholder expectations accordingly.”
3. Good corporate governance alone does not create value
The PwC study of how board structure affects value confirmed the view that good corporate governance is a necessary but not sufficient condition of value creation for shareholders. While some commentators have gone as far to suggest that corporate governance has become an analogue for value, they run the risk of dangerously simplifying a complex discussion. When PwC examined performance of companies in relation to size of their board, larger than average boards emerged as a potential impediment to value creation.
4. Hard facts on soft assets
As expected, the proportion of intangibles is greater in knowledge-rich industries. However the nature of intangible assets differs significantly between industries. In some industries the source of this competitive advantage may result from regulatory conditions (e.g. licences). In others it may relate to the organisation’s brand name. To complicate the matter further, these proportions and advantages change over time. In any event, the increased importance of intangibles as sources of corporate value under IFRS will mean:
Purchase price allocation will be required. This means acquiring companies will have to focus on the competitive advantages they gain, marrying the strategic rationale of transactions with financial accounting.
Impairment testing will effectively be required annually on a discounted cash flow basis. This will be a major short-term issue as 18 per cent of companies in the ASX200 have a market value (represented by their share price) lower than the carrying value of their assets, implying an immediate impairment concern.
5. Interest rate sensitivities
Interest rates may impact companies in unexpected ways, particularly those that do not usually think about interest rate risk, and even companies that do not borrow.
Many corporations with borrowings will already be questioning the degree to which their interest rate exposure is hedged. However, organisations without borrowings also have significant exposure to interest rates, though not all companies are affected equally.
This sensitivity of value to interest rates means that companies should:
consider hedging on interest rate exposure even if they do not have any borrowings;
consider expediting deals if the value of the company may be adversely affected by prospective interest rate rises.
6. Capital management remains key
The way capital is employed and financed are two important drivers of market performance. In terms of capital employed, our survey shows that performance remains disappointing. Around 60 per cent of companies fail to reach the market’s average required rate of return.
A higher return on capital employed is a proxy for both investment efficiency and competitive advantage. Accordingly, this is correlated with a higher intangible value. There is therefore an opportunity for many companies to increase market value by improving returns on capital, in effect capitalising on their competitive position.
The other side of the capital management equation is financing. Over the past three years, a low appetite for risk has meant that financing has tended to be more conservative.
The number of buybacks, special dividends, de-mergers, rights issues and placements in recent times indicates that managing the mix and sources of finance remains high on corporate to-do lists. Balance between cost of finance and its risk is the critical trade-off in these activities.
7. Getting caught in the capital raising rush
The number of companies floating on the ASX has dramatically increased in the past 18 months, with a very strong pipeline. On a PE basis, ASX pricing is comparable with that of major markets, liquidity is solid, volatility is low and, for a relatively small country, the value of the exchange is considerable.
Furthermore, the strong Australian dollar has provided an ideal opportunity for cross-border M&A transactions funded on-market.
However, although the ASX remains a good place to raise capital compared to international peers, our analysis indicates a risk for smaller company floats, which incur a substantial discount compared to large companies. This discount may be ameliorated by providing regular information updates, credible communication channels and open registers. Improvement in these areas has a greater relative impact for smaller companies than for large organisations. The PwC ValueWeb for UNiTAB
UNiTAB’s winning ValueWeb in the PwC Corporate Value Report features relatively low financial risk, high intangible asset intensity and good profitability in a highly regulated and consolidating market.
The shaded area, shown here, represents the overall measure by which shareholder value has been assessed. Relatively strong dimensions are closer to the edge of the web, while measures showing room for improvement are closer to the centre.
Low levels of share market liquidity suggest fertile ground for the company to explore options to derive more value from corporate activity and investor communication.
Value measures incorporated in the PwC ValueWeb include: 1. Market factors: total shareholder return (TSR) over the short and medium terms; volatility; capitalisation and liquidity; concentration of ownership. 2. Internal financial statistics: revenue growth; profit margins; economic return (i.e. return after the cost of equity capital has been deducted). 3. Standard valuation statistics: intangible value (market to NTA); PE ratios (adjusted for goodwill amortisation to distinguish organic v acquisitive growth); Altman z-score (an aggregate measure of financial health).
For further information contact PwC partner Richard Stewart richard.stewart@au.pwc.com
Tel: + 61 2 8266 8839
